Beware the Fed’s Balance Sheet Unwinding

Historical data shows that stock markets have reacted poorly when the Fed has contracted its balance sheet and reduced liquidity – and the effect is more pronounced when Fed actions deviate from what the market expects.

Federal Reserve policy impacts stock markets via two channels: bond yields – when the Fed buys bonds, yields tend to fall, reducing the discount rate for equities and increasing stock prices – and via the signals sent as the Fed’s balance sheet expansion/contraction impacts expectations of future macroeconomic conditions and thus expected future corporate earnings.

Tālis Putniņš’ “Free Markets to Fed Markets: How Modern Monetary Policy Impacts Equity Markets,” published in the second quarter issue of the Financial Analysts Journal, examined the impact of Federal Reserve policy on equities over the period 2009 through October 7, 2020. He began by noting that there are some limitations, mainly in estimating how the Fed responds to the stock market. The analysis does not distinguish between whether the Fed is reacting to stock prices directly or reacting to expected future economic conditions reflected in stock prices. He also noted that prior research had found that the Fed’s quantitative easing (QE), i.e., buying bonds, in response to the global financial crisis resulted in economically meaningful and long-lasting reductions in longer-term interest rates, and that policymakers at the Fed do pay attention to the stock market due to the consumption-wealth effect of stock returns – their tendency to cut rates in response to falling stock markets has been termed the “Fed put” by traders. Following is a summary of his key findings: